October 2, 2011

Economist Robert Litan of the Kauffman Foundation likes to recall that half of today’s Fortune 500 companies began as start-ups in a recession or a bear stock market. And why not? During a recession, it’s cheaper to hire new workers, rent office space, buy supplies. But Litan suspects the same process may not be working now. In contrast to earlier slumps, when the number of start-ups barely fell, there’s been a steep decline. From 2006 to 2009, start-ups dropped 27 percent.

That’s one cause of weak job creation, which depends heavily on start-ups. “It’s not encouraging,” says Litan. “It looks like more risk aversion.”

Americans see themselves as go-getters and risk-takers. Our optimism will ultimately rescue us. So it’s said. But the folklore increasingly collides with reality. The 2008-09 financial crisis traumatized millions. It swelled the ranks of risk-avoiders, worrywarts and victims. Of course, this was mainly a reaction to overborrowing, inflated home values and lost jobs. But now the fear factor is feeding on itself — and it’s smothering the recovery.

We are prisoners of our rotten mood. Everywhere, the bias is to spend less and wait to see how things turn out. Just as optimism sustained the boom, pessimism prolongs the bust. This is the reverse of “irrational exuberance,” because as long as most people feel this way, the psychology is self-fulfilling. Unfortunately, that’s how they feel.

Consider:

●Consumers: Confidence surveys show the longest streak of low ratings on record. The Conference Board’s index, based on people’s outlook and buying plans, sets 1985’s attitudes at 100 and, in good times, usually registers between 120 and 140. The latest reading (September) was 45.4; the low was 25.3 in February 2009. “We’ve never seen it drop so low and stay so low,” says the Conference Board’s Ken Goldstein.

●Corporate managers: As is well known, large companies have $2 trillion of cash and securities, up $520 billion since the end of 2007. That’s money firms could use to hire and invest in plants or new products — if managers were more confident. Instead, they’re stockpiling funds against another financial crisis.

●Small-business managers: “These are the most depressed numbers in history,” says Holly Wade of the National Federation of Independent Business, whose optimism index started in 1974. Only 11 percent of firms expect to hire in the next three months. Small companies (500 workers or less) represent half of all employment.

●Investors: Stock values reflect low expectations of future profits. One measure of mood is the P/E ratio: a stock’s price (P) compared to each dollar of per share earnings (E). High P/Es signal optimism. Today’s P/E is 13.8 for the Standard & Poor’s 500-stock index, well below the average of 18 from 1950 to 2011, says S&P’s Howard Silverblatt.

“Risk aversion” — understandable for individuals and firms — has become a collective curse. When everyone is super-cautious, the result is stagnation or worse. Imagine an economy doing just slightly better: Consumers work off some pent-up demand; stock prices are 10 percent higher; companies channel $200 billion of their cash to new products or plants; entrepreneurs nurture 10 percent more start-ups. A stronger recovery would be self-sustaining.

The good news is that this could happen. Mood swings can go both ways. Objectively, some economic conditions have improved. Households, for example, are much less indebted. Much mortgage and consumer debt has been paid down or written off. Federal Reserve statistics show debt service burdens (the share of income devoted to repaying) at their lowest levels since 1994. Consumers could be more expansive.

But that’s hardly preordained. Shifts in psychology mean shifts in economic behavior. One reason many 2011 forecasts were too optimistic is that economists discounted psychology. Some prominent forecasters have admitted the error. “Confidence normally reflects economic conditions; it does not shape them,” notes Mark Zandi of Moody’s Analytics. But at times, he says, “sentiment can be so harmed that businesses, consumers and investors freeze up. . . . This is one of those times.”

Fickle psychology also explains why massive economic “stimulus” (low interest rates, big deficits) didn’t trigger a powerful recovery. Government stimulus can be diluted if households and businesses move, for whatever reason, in the opposite direction. Paradoxically, the call for stimulus can cause consumers and businesses to retrench by focusing their attention on the economy’s weakness. Alternatively, people might be reassured if the government supports the economy with more spending or tax cuts. Some of both reactions apparently occurred.

Many real devils stalk the economy: housing’s collapse; Europe’s debt problems; persistent budget deficits. This is no time for happy talk. But acute risk aversion is a self-inflicted wound. Franklin Roosevelt was right: What we have to fear is fear itself.